Use Price To Profit And Grow

Pricing is one of the most powerful--yet underutilized--strategies available to businesses. A McKinsey & Company study of the Global 1200 found that if companies increased prices by just 1%, and demand remained constant, on average operating profits would increase by 11%. Using a 1% increase in price, some companies would see even more growth in percentage of profit: Sears, 155%; McKesson, 100%, Tyson, 81%, Land O'Lakes, 58%, Whirlpool, 35%. Just as important, price is a key attribute that consumers consider before making a purchase.

Most companies today set prices by marking up costs, maintaining margins, using fly-by-the-seat analyses, matching competitors and doing things the way they've always been done. While familiar and easy to implement, these prices bear no relation to the amount that consumers are willing to pay. As a result, profits are left on the table daily.

The price that consumers are willing to pay depends on the value they place on a product.

Street vendors in Central Park understand this pricing mindset. At the first hint of rain, they raise the price of their umbrellas. This increase has nothing to do with costs; it's all about the increased value that customers place on an immediate haven from rain.

The key to setting the right price involves "thinking like a customer."

Consider how you decide if a price is satisfactory. Most of us evaluate a few products and choose the one with the attributes and price that offers the best deal (value) among the various alternatives. Just to be clear, value rarely means the lowest price. Many times customers willingly pay a higher price for more attributes. Customers who select premium-priced brands are in essence saying, "I know that I can buy private label products for less, but I value the higher quality and trust the brand." By capturing the value of a product, setting prices by thinking like a customer reaps the highest possible margins.

2. Identify their next best alternative. What other product is in the target customers' consideration set? Use this next best alternative's price as a starting point.

3. Determine your product's difference. Of course if two products are identical, their prices have to be the same. Why would anyone pay more? But products are rarely identical--those with more attributes can command a premium. Conversely, stripped down products can be made attractive with the right discount. Most people decide that "the best" attributes of a Rolls Royce are not worth the hefty premium, for example.

So when comparing a product side-by-side with its next-best alternative, it is important to convey what makes it unique. Key differentiating characteristics include brand, quality, style, physical attributes, service, ease of purchase and style.

4. Calculate a product's value based on its differentiation. Once a product's differentiation is articulated, use experienced judgment (or market research) to understand the value offered to customers and set the appropriate price.

Value-based pricing enables sellers to confidently highlight what makes their products appealing, "Sure, the competition is cheaper, but our enhanced attributes are worth the premium" or pitch their stripped down product by questioning, "Are the bells and whistles of the competition really worth the extra money?"

Consider the owner of a beachfront house with a private pool who is setting a weekly rental price for vacationers. The next-best alternative is a rental house located next door that is identical in every respect except that it does not have a pool. A value-based analysis starts with the price of the next best alternative (say, $1,000) and then adds a premium (or discount) based on differentiating attributes. Suppose that from years of experience, it is known that the average vacationer will pay a 20% premium for a pool. The value-based price would be $1,200 ($1,000 plus a 20% premium).

A simple change in how companies think about pricing--focus on capturing the value that a product offers relative to its next-best alternative--unlocks new profits and growth. A value-based price should be the foundation of every company's pricing strategy. And here's the best part--reaping the benefits of better pricing does not require significant capital outlays or long "seed to harvest" periods to determine whether or not the effort pays off. Prices can be changed on Sunday night and new profits can start flowing in almost immediately.

Focusing on better pricing is usually the quickest path to new profits and growth.

What new profits can your company reap by setting value-based prices?

This article is adapted from The 1% Windfall: How Successful Companies Use Price to Profit and Grow (HarperBusiness, March 2010) by Rafi Mohammed.